How to Avoid Making Mistakes in Trading

We need to be aware of our thinking processes when making decisions in trading and investing – by Wolfgang Fallmann

Many traders and investors are losing money on the markets. They believe that they make rational and good decisions. Unfortunately, this is not true for most people and for most investment decisions. All too often we allow ourselves to be fooled into relying too much on our current mood, feelings and emotions when making decisions. We believe our first intuitive answer, but it usually causes mistakes. We tend to be risk takers when we lose and risk averse when we win. We tend to overestimate our knowledge of the world and underestimate the role that chance plays in events. Because our brain is not designed for this, we ignore statistical facts and overweight unlikely events.

Our decisions often do not match with the associated probabilities and we systematically deviate from the expected value, which is costly. When making financial decisions, we attach much more value to profits and losses than to the asset situation itself. These and other factors cause predictable errors in thinking. These errors lead to bad decisions and this in turn leads to losses in our investments.

There are essential principles which you should apply and adapt them to your personal needs and develop them further. These principles are the foundation for successful trading and investing in Bitcoin and cryptocurrencies. Admitting to yourself that you are making errors in judgment is the first and most important step. An open mind set and the willingness to exchange old beliefs for new ones is a basic requirement.

In the 1970s, two assumptions about human behavior were considered proven. First, people generally behave rationally, and they usually think clearly. Second, emotions such as fear, hatred, affection, etc. explain most cases where people deviate from rationality. Daniel Kahneman and Amos Tversky refuted this. In their New Prospect Theory, they analyzed decision making under uncertainty and concluded that people behave much more irrationally than expected.

The Two Systems

People have two systems with which they think:
System I: The fast, intuitive thinking
System II: The slow, cognitive thinking

System I is responsible for our fully automated perception processes and automated routines. It takes control in emergency situations to protect us and assigns top priority to actions that serve self-protection. It is always active; it cannot be turned off and that is the reason why mistakes happen to us that System II does not notice. Thinking happens automatically and unconsciously. It is stereotyping and emotional. System I works almost effortlessly. It is more influential than we subjectively feel and secretly controls many decisions. The reason why it is so difficult for us to think statistically is that System I is not designed for it.

System II is responsible for our slow thinking. It is the strenuous form of thinking. It is rarely active and we have to activate it, which takes effort. By activating System II, we act deliberately. It is tedious, it requires work and concentration. When System II is activated, our pupils dilate and the heartbeat increases. It requires attention and is disturbed when attention is withdrawn. It is logical, calculating and conscious.

Test your systems by solving this puzzle:
One baseball bat and one ball costs $1.10. The bat costs one dollar more than the ball. How much does the ball cost?

This example is known as the bat-ball problem. Over 50 percent of students at the elite universities of Harvard, Princeton and MIT gave the intuitive, but wrong answer. At other universities, over 80 percent were wrong. If your answer was 10 cents, then you relied on your intuitive, fast System I and gave the wrong answer.

Now activate your System II, think about this example again and find out the right answer.

The solution to the problem is as follows: The club should cost 1 dollar more than the ball. The two conditions – total cost equals $1.10 and club is $1 more expensive – are only met if the ball costs 5 cents and the club costs $1.05. This example shows that many people trust their intuition (System I) too much and do not question it by activating System II.

There are often conflicts between the two systems. System II is responsible for self-control and processes the impulses of System I. System II controls System I. This control is important because System I can lead to massive misjudgments. However, this control is exhausting and takes energy. So, to increase the quality of our decisions, we should activate our System II and think “slower”.

Watch this video before you read on.

Intellectual Abbreviations

Performing several things at once (multitasking) is only possible if they are simple and undemanding, such as driving a car and talking to the passenger. A vivid example of this statement is the Monkey Business Illusion by Daniel Simons.

This video reveals two facts about mental processes. First, we can be blind to the obvious and second, we are also blind to our blindness. When we focus our attention on something, we often overlook other unexpected things. This means that when System II is active, we are blind to other things. So, in our thinking we are subject to an illusion. We are deceived by ourselves.

Our brain is lazy and looks for mental shortcuts to reach a decision quickly. In psychology this is called judgment heuristics – simple rules for decision making. In many life situations it is rarely possible or often too time-consuming to research countless alternatives, estimate probabilities and then weigh them up rationally. People often like to disregard statistical facts and prefer to rely on simplifying heuristics to make a difficult judgement. This reliance on heuristics causes predictable errors (also called bias) in our predictions.

Especially when investing, we encounter these errors all too often and do not even notice them. One of the most popular heuristics is the affect heuristic. This means that we consult our mood, feelings and emotions when making judgments and decisions. It is a case of substitution where our brain replaces a difficult question such as “What do I think about it” with the easier question “What feelings does it trigger in me”. The problem is that we do not consciously notice this substitution.

In terms of cryptocurrencies this could look like this: We answer the difficult question “Should I invest in Bitcoin” with the easier question “Do I like Bitcoin?” without noticing this replacement. Results from studies have shown that test persons ascribe a greater benefit and a lower risk to a technology if they had a positive attitude towards it. If they did not like the technology, the disadvantages far outweighed the benefits.

In terms of cryptocurrencies, this means that investors are more likely to invest in a cryptocurrency if they have an affinity with it. In addition, it plays a role, as to how an investor stands emotionally in relation to a project and its use case. Depending on emotions, feelings and mood, buying and selling is influenced more or less strongly.

Emotions and feelings when trading and investing can lead to irrational decisions. Therefore, we have to become aware of them and eliminate them to a large extent. In principle, a longer investment horizon and less frequent observation of the market are highly effective against too strong emotions and feelings.

This is an excerpt of the book Crypto Investor Mindset by Wolfgang Fallmann, co-editor of the Smart Bitcoin Investor.